The Federal Reserve's favorite measure of inflation — the year-over-year change in the price index of core personal consumption expenditures — has been diverging from the more widely-followed year-over-year change in the core consumer price index, as Chart 1 illustrates.

The outlook for inflation is one of the key drivers of Fed monetary policy, so understanding the divergence — and especially why the central bank's preferred measure is so low — is becoming increasingly important.

Part of the explanation relates to medical care costs, as Goldman Sachs economist Alec Phillips explains in a note to clients (emphasis added):

Medical price inflation has been unusually restrained over the last several months, reaching a near-record low 1.1% year-on-year increase in August, and hovering just above that level since. While some of this reflects low inflation in the broader economy and it is possible that some of the slowing could signal an easing of medical price inflation for other reasons, we believe that much of the recent trend is also clearly due to exogenous policy influences: First, sequestration cut the price that Medicare pays for most services by 2%, along with the more publicized cuts to defense and non-defense federal spending. Second, the Affordable Care Act reduced payment rates for most segments of Medicare starting in late 2010.

We estimate that Medicare payment changes are holding down year-on-year inflation in the core PCE price index by 16bps, while the reduction in the core CPI index is a much more modest 2bps. To estimate this, we calculate the actual reduction in the reimbursement rate for each segment of Medicare (e.g., inpatient hospitals) as a result of the legislation. We then estimate the share of total spending for each healthcare service paid by Medicare and use these to estimate the effect on health care services inflation in each price index.

The effect on the core PCE index is much greater than the core CPI index mainly because of coverage differences. While PCE includes virtually all health spending, CPI includes only health spending paid by the consumer. Regarding Medicare, the distinction for inclusion in CPI is drawn by the source of financing: services financed by the Medicare trust fund ("Part A") are not included in the CPI, while services financed in part by monthly premiums ("Part B") are included.

Chart 2 shows how cuts to Medicare have affected the medical services inflation component of both core PCE and core CPI.

Without the cuts, medical services inflation would be significantly higher in the core PCE index.

Phillips says most of the effects of the Medicare reimbursement reduction should fade in 2014.

"First, sequestration should have only a one-time effect on medical price growth," writes Phillips.

"The effect on the level of prices resulting from the cut will remain in place through the end of the decade, but no further reductions will take place under sequestration so there will be no further effect on the growth of payment rates. Sequestration for Medicare took effect in April 2013 — a month later than for other categories of spending — so the year-on-year effect of sequestration should disappear in April 2014."